The first of two articles on private equity looks at the humbling of America's venture capitalists, the second at Europe's maturing buyout market

START-UPS are risky—except, you might say, for venture capitalists. Although investors and entrepreneurs have suffered badly over the past couple of years, venture firms have collected more fees than ever for managing their funds.

Until now, that is. The funds' limited partners (mostly pension funds, university endowments and rich individuals) are now pressing the venture capitalists to share the pain—with some success. In recent weeks, several leading Silicon Valley venture firms have announced changes that amount to accepting a pay cut.

Mohr, Davidow Ventures was the first to take that step, by reducing its most recent fund from $843m to $652m, thus lowering the management fees its limited partners have to pay. Then Kleiner Perkins Caufield & Byers, the alpha males of venture capital, in effect cut their fees by a quarter. Accel Partners is proposing to split its $1.4 billion fund in two, forgoing fees on the second half until 2004. Cue Schadenfreude among those who blame venture capitalists for the dotcom bust.

Venture firms make money in two ways. They get a share of a fund's profits (the “carry”), and they also earn a percentage of the capital committed in management fees, regardless of whether the capital is actually invested. Traditionally, the carry was 20-25% and the fee 1.5-2.5%, depending on a firm's record. An average venture firm managing a $200m fund could thus make $4m in annual fees, which sounds quite reasonable.

With the dotcom boom, however, things got out of hand. Venture firms started demanding a higher carry and higher fees. More importantly, the funds exploded in size, often reaching more than $1 billion. Some venture capitalists, dubbed “drive-by VCs”, ended up sitting on more than a dozen company boards.

Investors were happy so long as the money could be invested quickly and yielded a healthy return. Since the Internet bust, however, general partners have had a harder time investing the money they have raised: undeployed venture capital is estimated at $45 billion in America alone. Venture capitalists are spending most of their time trying to salvage start-ups in their portfolios rather than seeking out new targets. The average portfolio has lost over a third of its value in the past year.

All this is particularly painful for the limited partners, most of them entrepreneurs, who invest their own money. What seemed a small commitment in boom times is increasingly a significant portion of an individual's net worth—which is why Kleiner Perkins Caufield & Byers cut its fund. Other firms, such as Benchmark Capital, appear less understanding, a fact that has led Eric Greenberg, founder of Scient, an Internet consultancy, to attack the firm publicly.

Might such conflicts lead to a wave of lawsuits between limited and general partners? Investors recently sued MeVC and idealab to get back some of their cash. But these are special cases: MeVC is a publicly traded venture fund and idealab an incubator. Other venture firms are working hard to avoid court fights, to preserve precious relationships with investors. Some venture firms may vanish, though. The Barksdale Group, founded in 1999, has called it quits. Others may follow once their current funds have been invested.

If there is a lesson in all this, it is that limited partners need to think twice about what they sign up for. The people who run the funds, for their part, should realise that there are limits to how much money a firm can reasonably manage.

The venture business will no doubt see better days again. In fact, although investments reached a new low in the first quarter, venture firms are starting to put money into brand-new firms again, particularly in biotechnology. But it is unlikely that venture capitalists will regain star status soon. That doesn't seem to worry them. As one puts it: “It's nice to be back in an era when the VCs are only nominees for best supporting actor instead of best actor. Entrepreneurs should be centre stage.”